Moral Hazard

MORAL HAZARD

Definition of asymmetric information: This is a situation where there is imperfect knowledge. In particular it occurs where one party has different information to another. A good example is when selling a car, the owner is likely to have full knowledge about its service history and likelihood to break down. The potential buyer, by contrast, will be in the dark and he may not be able to trust the car salesman.

Asymmetric information is classified into two categories - Adverse Selection and Moral Hazards, and I will be dealing with the latter. 

Definition of moral hazard: Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other.

Description: In a financial market, there is a risk that the borrower might engage in activities that are undesirable from the lender's point of view because they make him less likely to pay back a loan. It occurs when the borrower knows that someone else will pay for the mistake he makes. This in turn gives him the incentive to act in a riskier way. This economic concept is known as moral hazard.

Example: You have not insured your house from any future damages. It implies that a loss will be completely borne by you at the time of a mishap like fire or burglary. Hence you will show extra care and attentiveness. You will install high tech burglar alarms and hire watchmen to avoid any unforeseen event. But if your house is insured for its full value, then if anything happens you do not really lose anything. Therefore, you have less incentive to protect against any mishap. In this case, the insurance firm bears the losses and the problem of moral hazard arises.

 

Citation:

"Moral Hazard." Timesofinida - economictimes. Web. 10 Jan. 2016.